Want a 14% Annual Distribution Yield? Try This Pair Trade

 |  Includes: AGNC, GGN
by: Todd Johnson

I recommend a paired trade with a long position in two securities. The first is Gabelli Global Gold, Natural Resources & Income Trust (NYSEMKT:GGN), a closed-end fund that's owned for insurance against U.S. monetary inflation and to proactively participate in the Federal Reserve's quantitative easing policy. The second is American Capital Agency (NASDAQ:AGNC), which pays a significant dividend based upon the Federal Reserve's intent on keeping U.S. Treasury Bond interest rates artificially low. Both GGN and AGNC pay significant distribution yields whilst mitigating risk by owning both in tandem.

GGN pays a 14-cent monthly distribution, which equates to a $1.68 annual payout. I typically focus upon closed-end funds with a 10% annual distribution payout, and selling at a discount to net asset value. GGN is an anomaly to this rule. GGN offers a 9.3% per annum distribution yield while trading at $17.96. GGN's net asset value is currently $17.41. The 3.15% premium to net asset value is acceptable due to the security's unique benefits. GGN earns income via selling covered calls, earning portfolio dividends, and accrued interest. The security is operating at a low preferred shared leverage of 9.22%. In contrast, many closed-end funds trade with a 20-30% effective leverage rate.

As long as U.S. Treasury Bond rates remain low, precious metals will remain high. Metals priced in U.S. dollars will be expensive when compared to stronger currencies. A currency with artificially low interest rates will not attract investment dollars compared to higher perceived net returns via alternative currencies. Quantitative easing is not an ideal monetary policy. Printing currency for interest rate manipulation has long-term dangers which can not be ignored. GGN offers the benefit of earning in excess of 9% per annum in distributions. In addition, the underlying equities will benefit by lofty precious metal prices and a weak U.S. dollar valuation.

AGNC offers close to 19% in annualized distribution yield. AGNC is an agency-backed mortgage real estate investment trust, also known as an MREIT. AGNC has announced typical quarterly $1.40 per share distributions. Based upon a current AGNC share of $30, the distribution yield offers a 18.7% per annum yield. The investor must recognize the wrong time to own MREITs is when U.S. Treasury Bond rates are increasing. The Federal Reserve, if dismissing quantitative easing as a modus operandi, is likely providing a wink and a nod that higher U.S. Treasury yields are on the horizon.

AGNC is a play on artificially low interest rates. A Federal Reserve policy, ceteris paribus, which advocates quantitative easing, will mitigate short-term higher interest rate exposure. Management's strategy is to maximize quarterly earnings. Earnings are derived between the difference of interest income earned versus the interest rate costs of borrowings and portfolio hedging actions. If U.S. Treasury Bond yields increase, then the cost of hedging and borrowing will detract from the merits of owning an MREIT. AGNC was currently leveraged; see page 34 of the recent 10Q, at a 7.6 multiple. Relative to its peers, AGNC is operating within industry acceptable leverage levels.

Current 14% Paired Trade Distribution Yield

Collectively, this trade -- GGN's 9.3% per annum yield and AGNC's 18.7% per annum yield -- offers an averaged 14% per annum distribution yield. A high yield assumably equates to a high risk investment. My trade is not a buy-and-hold position. Understanding the risks requires due diligence and going-with-the-flow based upon the current investment background. GGN is recommended based upon the investor understanding the merits of owning precious metal securities. A basic understanding of covered call premiums permits the investor to recognize how GGN's income is achieved. An example: Assume GGN owns Newmont (NYSE:NEM) common stock, and GGN management actively sells covered calls against the long Newmont common stock position.

Understanding AGNC requires understanding the interest rate background espoused by Federal Reserve chairman Ben Bernanke. When the quantitative easing policy is abolished, higher U.S. Treasury Bond interest rates must be on the investor's radar screen. Until then, I'm going with what is working. High gold prices and low U.S. Treasury Bond interest rates provide a current 14% annual yield. My portfolio is comfortable with this paired trade and the risks involved.

Disclosure: I am long AGNC, GGN.